The Great China Conundrum

Probably the biggest "X-factor" in the ongoing effort at reviving the global
economy is China. China is seen by many as the world's emerging industrial
powerhouse and its relationship with the United States is considered to be
crucial for its own development, as well as for the strength of the world economy.
With the U.S. in the role as the world's premier consumer and China considered
to be the major industrial player, all eyes are on the respective economies
of these two great nations.

There are two dominant views regarding China's economic outlook and its prospects
for total recovery from last year's credit crash. The first one states that
China is essentially a repeat of the Soviet Russian experience in that China's
dictatorial control by its communist rulers will keep it from achieving true "superpower" status.

The other view maintains that China is, in fact, on its way toward economic
superpower status that will eventually allow it to eclipse the U.S. The pro-China
view posits that China is well on its way toward developing its own internal
economy and that its former reliance on the U.S. for exports is gradually fading.
In other words, under this view China is "decoupling" from the western nations
as it becomes less export-driven and more reliant on a strengthening domestic
economy.

The negative view on China's economic outlook can best be summarized in the
following paragraph as stated by one respected observer of China affairs:

"Strong evidence suggests that China today has overstated its growth every
year, and yet the U.S. Government, gigantic American corporations and the big
TV-newspaper media swallow every falsified Red statistic whole. As we said,
if communism - and despite years of lies China is almost completely communist
in its command and control structure - is such an all-fired superior way of
organizing an economy, there should be examples of that right there in Asia.
But what do we see? China itself has been communist since 1949. That is 60
years. Yet nearly 1.2 billion of its 1.3 billion people still live in abject
poverty. That is more than 90%." [Source: Andrew Rothovius' U.S.A./China Letter,
June 2009]

In his China Hotline of June 9, Adrian Van Eck espoused the negative view
on China when he wrote, "[Some] say that China's banks are in better shape
than those of the rest of the world. That is also not true. China's banks are
government owned and they lend billions of dollars to money-losing, state-owned
firms in violation of World Trade Organization rules. Then the Government replenishes
this money and they start over again...making loans intended to allow Chinese
firms to sell at money-losing prices and steal millions of jobs in America."

Underscoring the negative view of the Chinese "economic miracle," Mr. Van
Eck also stated in the August 2009 edition of his Money Forecast Letter, "All
the fantasies about [the U.S.] being passed by in the next few years by the
likes of China, India, Russia, Brazil, etc., will be exposed as the idle day-dreams
they really are."

Elsewhere he writes, "But there is one nation that is riding a bubble right
now and that nation is the People's Republic of China. Henry Kissinger once
told President Nixon that the Chinese People are the smartest on earth. Yet
there is a defect in their official national character that has brought them
from very high levels of achievement to very low levels of failure a dozen
times over the past 4,000 years. They would build dynasties and conquer nations
on all sides, forcing these captive people to pay tribute to the Chinese Imperial
Court. But then pride turned to arrogance and arrogance caused them to make
mistakes - big mistakes and a lot of them. Most of these mistakes had to do
with corruption at home, and that is exactly what is showing up these past
few years....

Van Eck continues, "Each time that one of their dozen rich dynasties fell
China endured long periods of awful poverty. I suspect that will happen again.
Now that the Chinese State Bank is spreading billions of dollars in loans around
to encourage wild consumer spending by communist party members...all to replace
lost sales resulting from the sharp drop off in American consumer product imports
from China. China's money has been pushed up in value 20% since Bernanke took
over the Fed. Greenspan allowed them to cut the value of their Yuan by a lot
(the higher the number per dollar the cheaper the yuan) and then freeze it.
Because of strong domestic inflation, China can no longer afford the kind of
cheap prices they have offered. The game is about over for them. And at the
same time I expect manufacturing plants to begin coming back to America." [Source:
The Financial Research Center, Inc. Money Forecast Letter, August 2009]

On the other side of the debate, one of the biggest exponents of China as
a dominant economic force is George Soros. Soros has been quoted as saying, "China
is going to be a positive force in the world and the market, and as a consequence
its power and influence are likely to grow. Personally I believe it is going
to grow faster than most people current expect," adding that "China's aggressive
4 trillion Yuan economic stimulus package last year has bolstered the economy." He
cautioned, however, that because China's economy is only a quarter the size
of America's economy, "It cannot replace American consumers as the motor of
the world economy."

A U.S. expat living in Shanghai recently gave me his assessment of China's
economic situation. Quoting him at length:

"First, after the October 2008 meltdown, the mood was grim and the term "Financial
Crisis" was on everybody's lips. Business announced hiring freezes all over
town - although I did not hear of any layoffs in the Multi-national companies
I frequent. Down in Guangzhou, of course, it was a different story - as millions
of migrant rural workers in Guangdong Province factories were laid off, and
there were many riots.

"What a difference a $600 Billion stimulus makes. Beijing flooded the country
with stimulus money, and it seems to be working (sentiment-wise). Everybody
is now optimistic again. Whereas before, there was a lack of interest in the
high-priced real estate here - the interest and investment is back. Companies
are optimistic and looking forward to the future - if they are NOT export-driven.
But those companies that specialize in exports are still sucking wind. The
auto and auto parts industry (for export) have been decimated. Come to think
of it - I haven't seen an expat buddy of mine lately since he got laid off
from his auto parts company several months ago. But American and European expats
from all sorts of industries are getting called home in droves - and that is
continuing.

"Hard to figure out this multi-faceted economic elephant - but if I had to
put it in a nutshell - it's this: Export-dependent companies are hurting, but
what with the stimulus freeing up bank lending and infrastructural development,
companies that focus on domestic production and consumption are doing well
and are optimistic about the future again, even though there is an employment
problem with young college graduates that can't find a job (the job market
is not expanding, to my knowledge, but there are no mass layoffs).

"It has me guessing. I've been quite surprised by the turnaround. It looks
like China is much less export-dependent for its growth than I'd thought. Perhaps
the great "decoupling" theory is correct after all. Then again, there is that
$600 billion in stimulus. So, time will tell whether this turnaround is sustainable
on its own."

A definite prediction of where China's economy is headed in the longer-term
outlook is beyond the scope of this commentary. Our main concern is the intermediate-term
outlook for China's stock market, which in turn tends to lead economic performance.
For that reason we developed the CHINAMO internal momentum indicator series
earlier this year and are using them to point to strength or weakness within
the market for U.S.-listed Chinese shares. CHINAMO has a secondary application
of predicting where the general economy for China is headed in the interim
outlook since major stock price trends tend to precede, or at least coincide
with, economic trends.

This summer, China's benchmark Shanghai Composite Index fell more than 20
percent below this year's high, supposedly on concerns that China's economic
recovery would falter as its government curtails lending. Moreover, there are
signs that since hosting last year's Olympic Games in Beijing, China's economy
is suffering from the infamous "Olympic Curse."

The lynch pin behind the rally of U.S. listed Chinese stocks (as reflected
in the various China ETFs) has been the fact that the dominant longer-term
internal momentum indicator for the China stock group has been in a strong
uptrend. This has held true since earlier this year when the market recovery
first began and continued through the summer, even when the Shanghai Composite
Index had its 20% + decline. The short-term momentum indicator (dark blue line)
and the internal trend (pink line) have been in decline since June, as has
the sub-dominant interim momentum (orange line). More recently the dominant
interim momentum indicator (light blue line) has started to roll over into
a downtrend. Yet all the while the long-term momentum indicator (circled) continued
its rise. Until now...

As the circled indicator shows, long-term momentum has apparently peaked and
is just starting to reverse its uptrend. Assuming this continues to accelerate
into a downward trend it will eventually lead to a bumpy ride for the China
stocks and another fall in the Shanghai index likely to follow.

Clif Droke is a recognized authority on moving averages and internal
momentum. He is the editor of the Momentum Strategies Report newsletter,
published since 1997. He has also authored numerous books covering the fields
of economics and financial market analysis. His latest book is Mastering
Moving Averages. For more information visit www.clifdroke.com